China: shifting focus from financial to environmental health

11
April
2018

By Mark Evans, Analyst

Last month we attended a trip hosted by CICC in China to gain a deeper ‘on the ground’ understanding of the health of the Chinese economy. This was a commodities and macro focussed trip and the third consecutive year we attended. The government’s reform efforts in reducing excess supply in the economy continue to impress. Upstream industries are in generally much sounder financial health relative to my first trip in 2016, and the reform focus has clearly pivoted away from financial to environmental health, consistent with remarks over recent months by President Xi. It’s widely expected commodity prices should be supported by reduced supply, although shifting attention to cleaning up the environment may have some unintended consequences for demand.

Xi’s supply side reforms keeping the steel market balanced

To its credit, the government’s ambitious attempts to tackle inefficient steel production and revive profitability is clearly working. My visit to Tangshan, one of China’s big steel producing cities, was testament to that with ‘diamond-effect’ paintwork on Range Rovers, Lamborghinis outside the front of hotels and generally more ‘German metal’ on the road than my previous visits. Aside from these anecdotes, clearly regulatory and financial tightening has forced inefficient producers out of the steel market, with larger and more profitable operators who benefit from economies of scale still producing at near full capacity. Secondly, the government’s core objective of cleaning up the environment is forcing steel mills and other industrialised factories to reinvest in cleaner infrastructure to decrease pollution levels. What I found interesting was how local government officials, far from ignoring Beijing’s call for tighter environmental policy given the negative implications on growth, are implementing a stricter framework than Beijing is pushing for.

For example, we heard that the white smoke emissions from steel mills will not be allowed in Tangshan from November this year, despite the lack of producers with appropriate technology. While measures like this are likely to be watered down, it does highlight the seriousness of local authorities’ environmental conservation efforts. Clearly over tightening risks exist as the government’s focus shifts from quantity to quality of economic growth. However, we gain some comfort from the significant improvement in the coordination of policy and implementation over the last two years, and hence I think any signs of overtightening will be dealt with accordingly.

Tariff anxiety?

Steel producers and other market participants we spoke to weren’t overly concerned with the pick-up in protectionist rhetoric and policy from the US. The general sense was policies implemented so far were relatively modest in their effect, while any significant tightening would be self-defeating for the US. Admittedly I was a little surprised to see such a relaxed attitude, although we generally concur with the view, as detailed in a blog piece released last week. Moreover, discussions with a couple of reputable economists also highlighted risks from domestic overtightening far outweighed those of a trade war.

Soft economic activity data

The timing of the Chinese New Year (CNY) makes analysing and interpreting recent soft data prints extremely hard. Chinese demand data generally goes through a seasonal lag following CNY, but it seems to be uncharacteristically slow to recover this year. At this point and as a result of discussions from the trip, we believe that demand is delayed rather than permanently reduced. We are closely monitoring inventory levels of steel which appear to be moderating and hence provide some comfort that demand has merely been delayed rather than reduced. Weakness should therefore recover during the second quarter. Furthermore, consumer and business confidence surveys continue to point to a healthy macro-backdrop.

Portfolio positioning

Despite slightly reducing some risk in our emerging market debt and emerging market multi-asset strategies before the recent sell-off, we are still positive on the global growth story. China’s contribution to the world economic expansion remains significant, and hence our constructive view on China supports our positive outlook on global growth. In our view, further sell-offs in asset prices relating to a Chinese growth slowdown will provide us with a good opportunity to increase risk at more attractive levels.

In terms of bottom-up positioning, we still hold a long position in the renminbi against other regional peers. The closing interest rate differential with the US (i.e. difference between US and Chinese interest rates) creates some challenges, but overall the balance of payments are in a robust position. Capital outflows remain contained, capital inflows are also gaining traction thanks to recent liberalisation measures and benchmark announcements, while strong global growth is continuing to underpin healthy export growth. Furthermore, we also think renminbi strength is welcomed by the authorities as it helps to contain capital outflow pressures while also assisting in trade negotiations with the US.

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